Priced for Perfection
Stocks have climbed higher over the past two months, despite historic unemployment levels and continued reports of economic decline, not to mention the still-uncontrolled virus spread. The simplest reason equity prices have moved higher is that economic and health data is looking better. Importantly, though, “better” does not necessarily mean “good”. As we move toward summer and initial attempts at re-opening the US economy, clients and friends are asking, why this dramatic disconnect?
We have often discussed the way that markets discount future earnings to determine today’s prices. Those prices reflect management decisions yet to come, product line and market share expansions (or recoveries) that haven’t yet happened, patents or medications in development but not yet approved. Markets are optimistic when it comes to these possibilities, especially if they reinforce an existing trend, or are compellingly presented by management. It is human nature to confidently bid up the price of something you assume will come to pass.
Markets have done just that in April, and to a lesser extent, in the second half of May. April saw recoveries in the S&P 500 and the Dow Jones averages of 11-12%, and in May overall they are up a further 3.5%. Early in the month, trailing economic data from April was off-the-charts negative. Nonetheless, investors bravely looked forward to the anticipated economic re-opening, and prices lost very little ground. In the last two weeks, the market pushed higher, encouraged by possible progress with vaccine efforts, and visuals on television and social media of people back out in public over Memorial Day weekend.
The presence of people in public spaces does not necessarily mean spending, though. As Canadian economist David Rosenberg quipped, those images have “the markets thinking ‘spending growth’ as opposed to ‘second wave.’”1 In fact, US consumer spending in April fell -13.6%, slightly more than projected during a full month of shelter-in-place practices. Personal income was up +10.5%, due primarily to the huge amount of government stimulus benefits paid. Overall, with continued uncertainty, the personal savings rate surged to an all-time high of 33% (more commonly between 6% and 8%).2
In this moment of market optimism, and clear economic struggles, the disconnect between prices and on-the-ground recovery seems too large for one or the other not to experience a major turnaround. Will it be the market turning tail again and prices falling, or the economy revving up?
The Case for Growth
To start with, the plus column includes the unprecedented set of monetary programs that the Fed has put in place over the last two months to support liquidity, and the financial markets generally. The extraordinary speed of the monetary and fiscal response to the pandemic has encouraged markets as well. They imply that results will be speedy, and investors will be rewarded for their optimism. Fed comments have also suggested that there is more stimulus to come if the market falters.
Further, stock price growth in a forward-looking market is not dependent on good news in an absolute sense, but continued evidence that the economic environment is improving and better than expected. On an absolute basis, more than 40 million Americans have filed for unemployment since early March. The rate of increase is slowing week by week, however, and totals have come in at lower levels than expected. The market has, and may continue, to rally on this relative positive.
Oil traders have also focused on incremental upticks in demand, and negotiated production cuts finally took effect after the oil market nearly seized up in April. Slowing virus transmission rates and detailed conversation of phased re-openings globally both led to tentative expectations of rebuilding demand, which has helped the price of oil recover to about 55-60% of its pre-COVID price level. While insufficient for oil producers to be profitable in most cases,3 the swift recovery has helped breed more optimism among investors.
Lastly, the ultimate case for growth is the narrative that the development of a vaccine is progressing on a faster timeline than ever before. Biotechnology companies, national governments, and NGOs around the world have jumped into this effort, and reduced regulatory hurdles in support of faster cycles of testing that may yield results. Even if the gap between discovery and distribution is many months or a year away, the market will rally substantively once there is certainty that relief (and higher economic activity) is on the horizon.
The Contrary Case
We are three months into a market that has ricocheted down and up with the daily news of the coronavirus and policies designed to balance public health with economic impact. The way through is not yet clear to policymakers – not in health care, not in education, not in state or local government – and the uncertainty is exhausting everyone.
Figuring out how to actually make it happen is exhausting as well, and costly. Designing return to work plans that use space differently, re-configuring restaurant meals for a public that is either required to or prefers to pick up than to dine in, balancing huge public budgets by cutting services drastically – all are increasingly directing a larger portion of staff time towards work that doesn’t directly increase revenues, and therefore has only a limited impact on economic growth. Any future waves of virus spread will slow this progress as well, and once again increase stress on the healthcare system and overall mental health.
While the speed of monetary and fiscal stimulus has indeed helped cushion the blow to the cash flow problems that individuals and businesses are experiencing, that help is short term in nature. It has bridged the gap of liquidity panic, but more will be needed on the fiscal side to truly start to rebuild. The HEROES Act passed by the House has not yet been approved by the Senate, and even that will also be mostly filling in potholes, and not building new roads.
To “build new roads” though, we would need a massive national work program. As businesses, schools, and government offices re-open, many expect to employ fewer people than before. State and local municipalities provide more employment than the federal government, but they cannot run a deficit, and are currently facing likely cuts of 20%+ to balance their budgets. One common way to balance a local budget is to cancel open positions and freeze new hiring, which is exactly what we don’t need. On the small business front, a survey in early May found that 52% of small business owners expected to be out of business within six months.4 And despite high profile coverage of Amazon and Walmart hiring, many large employers such as Boeing, IBM, Uber, and Chevron have announced plans to cut significant numbers of jobs.
Looking beyond our borders, the status of global trade going forward is unknown. China has taken a bold step to reclaim more sovereignty over Hong Kong, and just today the US made clear that it will take actions to punish China and reduce the effectiveness of the World Health Organization by withdrawing US participation and funding. Global cooperation supports global trade, but these sorts of nationalizing contractions do not. To what extent business between China and the US will become more difficult we do not know, but adding policy barriers to pandemic barriers cannot help.
Patience and Optimism
In a time of historic, extraordinary uncertainty, markets are pricing in its opposite – certainty. The classic phrase “priced for perfection” definitely applies today, with investors’ apparent certainty that we’ll find a vaccine, that unemployment will return to historic low levels, and economic activity will be whirring before we know it. This sort of certainty amidst uncertainty augurs disproportionate risks in equity markets.
While we remain hopeful for the longer term, and continue to hear about coronavirus-prompted innovations likely to support improvements in productivity, in the shorter term we think the challenges are enormous. Patience is required in a time of uncertainty. With the markets, we feel it is time to put patience into action, and keep optimism in our back pocket for the future.
1 Rosenberg, David, “Breakfast with Dave” economic commentary by Rosenberg Research, May 26, 2020.
2 For reference, over the past five years prior to March, the savings rate has ranged between 5.9% and 8.8%.
3 Most shale producers in the US budgeted for oil to range between $55 and $65/barrel in 2020 to support the costs of drilling and distribution. Certain wells for certain companies are profitable at lower prices, though. See Jennifer Hiller, “Few US shale firms can withstand prolonged oil price war,” Reuters, March 15, 2020.
4 Society for Human Resource Professionals, “52% of US small businesses predict failure within six months,” May 6, 2020. The sample included owners or executive officers of 375 businesses with 2-500 employees.
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